A Pro-Market Case for Taxing the Super Rich

Academics can be dismissive of the concerns of the popular media. But when it comes to the growth of the super rich, the tabloids may have it right.

The numbers tell the story. According to a study by John Van Reenen of the London School of Economics and Brian Bell of Oxford University, the share of national income earned by the top 1 per cent in the United States surged to 18.3 per cent in 2007 from 8 per cent in 1979. In Britain, the trend was almost identical: The top 1 per cent received 15.4 per cent of the national income in 2007 compared with 5.9 per cent in 1979. (Figures exclude capital gains.)

While much of the shift in income distribution has been at the apex of the pyramid, that is not where most academic research on rising income inequality has been focused. Prof. Van Reenen said academics “have tended to focus on the bottom of the distribution, much more than the top.”

Last month, he convened a panel discussion about extreme wage inequality at the annual get-together of the American Economic Association. One of the most striking research findings will probably give comfort to the plutocrats: In contrast to previous generations, today’s super rich tend to have earned their fortunes rather than inherited them.

Steven Kaplan of the University of Chicago and Joshua Rauh of Stanford University in California studied Forbes magazine’s annual list of the 400 richest Americans. They found that in 1982, only 40 per cent of these plutocrats had built their own businesses. By 2011, the super rich had become much richer; the combined wealth of the Forbes 400 was $92-billion (U.S.) in 1982 and had surged to $1.53-trillion by 2011 – and many more of them had built it themselves: 69 per cent.

Among economists who study the surge in pay at the top, it is pretty much a truth universally acknowledged that taxes should rise at the summit, too. “Economics would suggest that when you have big increases in inequality, the top tax rate should rise,” Prof. Van Reenen said. “That seems very right and very reasonable.”

The impact and the structure of higher taxes for the rich are a more complicated and controversial issue. Timothy Besley and Maitreesh Ghatak, both of the LSE, make a robust case for higher taxes on bankers’ bonuses. Their work is theoretical, but beyond the campus green, what may be particularly interesting is the way they frame the wider debate.

“Little undermines the case for a market economy more than the perception that there is injustice in the rewards that it generates,” they argue in a recent LSE paper.

“We have shown that some form of bonus taxation in the financial sector is optimal above and beyond standard progressive income taxation,” they conclude. “We have identified a form of taxation that we believe makes the market system both fairer and more efficient.”

This robustly pro-market rationale for higher taxes on bankers, who like to think of themselves as the embodiment of capitalism, is eye-catching, particularly in the United States, where higher taxes and more efficient markets are usually portrayed as being anathema to one another.

Emmanuel Saez, an economist at the University of California, Berkeley, and one of the pioneering students of incomes at the very top, has offered an even more provocative suggestion.

At the recent economic association meeting, he argued that when tax rates at the top are low, “top earners extract more pay at the expense of the 99 per cent.” Higher tax rates for the rich, he suggested, “reduce the pretax income gap without hurting economic growth.”

This is a radical idea – that higher taxes at the top can reduce pretax inequality and not weaken the economy as a whole.

Outside the seminar room, however, these elegant ideas may run into political opposition that is intensified by the trends within the 1 per cent that these same economists have documented.

“It may have a political effect,” Prof. Van Reenen said of the shift from inherited fortunes to self-made ones. “You feel you’ve earned it. This does make people more strongly inclined to resist taxation.”